Shocking Court Decision Makes Borrowers Liable on Nonrecourse Indebtedness

January 16, 2012

An extraordinary decision by the Michigan Court of Appeals should place asset protection planning at the forefront on the minds of all individuals who have outstanding nonrecourse guarantees of commercial loans. As a result of the decision handed down by the Court in the case of Wells Fargo Bank v. Cherryland Mall Limited Partnership, David Schostak and Schostak Brothers & Co. (December 27, 2011), real estate investors/developers employing nonrecourse commercial mortgage-backed securities ("CMBS") loans now find themselves personally liable for any deficiency if the loan defaults. You are undoubtedly wondering: if these are nonrecourse loans how can the loan guarantors become liable for the unpaid debt?

It turns out that there is standard language in these CMBS loans which requires that the property be held by a single purpose entity ("SPE") and that the SPE remain solvent and pay its debts and liabilities as they become due. According to the Court's interpretation of the loan documents (the Mortgage, Note and Guaranty), the breach of the borrower's covenant to remain solvent destroyed its SPE status and thereby triggered full recourse against the guarantor.

When entering into these loans, a guarantor understands and accepts liability for losses incurred by the lender as a result of so-called "bad acts" such as fraud, intentional misrepresentation, misappropriation of rents if the loan is in default, etc. However, the notion that the guarantor could become liable for any deficiency because of the insolvency of the principal obligor is an alien concept and defeats the whole purpose of the obligation being nonrecourse against that guarantor. Indeed, the primary reason for negotiating this type of loan is to avoid personal liability if the deal goes south.

Interestingly, the Court fully understood the ramifications of its decision in this case when it stated: "We recognize that our interpretation seems incongruent with the perceived nature of a nonrecourse debt and are cognizant of the amici's arguments and calculations that, if accurate, indicate economic disaster for the business community in Michigan if this Court upholds the trial court's interpretation. Nevertheless, the documents at issue appear to be fairly standardized nationwide, and the defendants elected to take that risk--as did many other businesses in Michigan and nationwide. It is not the job of this Court to save litigants from their bad bargains or their failure to read and understand the terms of a contract."

Certainly, if you have guaranteed any of these loans and there is any concern that the borrower will be unable to meet its debt service obligations, you need to be aware of the potential consequences and the exposure of your personal assets to the lender for any deficiency (as well as attorney fees and other costs incurred by the lender). This case, perhaps more so than any other development in recent years, points out the prudence of being proactive with regard to asset protection planning and insuring the safety of your personal assets.

If you feel that you might benefit from consulting with an asset protection planning attorney, please feel free to contact me.